How to make use of compounding in your FX trading

ALBERT Einstein reportedly said that compound interest is “the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”

There are examples of compounding in FX. One FXCM client, for instance, invested $14,000 over the last two years and made a $100,000 return. How? First, they held positions for 28 days on average. Second, the trader would only trade in line with strong trends. Finally, they would add to winning positions. While this formula is not necessarily a sure route to success, it’s still the opposite of what the average FX trader does. The average trader will add to losing positions, trade against the trend, and will trade three times a day.

How have I incorporated compounding into my trading? While I will add to winning positions, I also relate all my risk to a percentage of my account. For example, say that I spot a viable trade idea. To try it out, I might be willing to suffer a maximum loss of 3 per cent of my account. If I am right, I will have made a gain, and the next time I trade I will naturally have more money on my account. Then, my “3 per cent max loss” will not really be 3 per cent of my initial investment. In fact, the risk will be 3.09 per cent.

After 10 winning trades of an equal amount of risk, my “3 per cent” will be 34.39 per cent. This is important to remember, and it does give hope to people who want to become overnight successes. A great example of the wonders of compounding are the returns of Warren Buffett’s Berkshire Hathaway. They have been on average 22 per cent per year. Anyone with patience could be set for long-term success with the help of compounding.

Alejandro Zambrano is a currency strategy analyst at DailyFX.com